What is a Waterfall and Promote Structure in Commercial Real Estate?
A waterfall and promote structure, also known as a waterfall model, is a method for distributing the profits from a real estate investment in an uneven way. Typically, the project's sponsor (the individual or group putting most of the work in to identify, acquire, and manage the property) receives a disproportionate share of the profits, known as a promote, as long as the project hits certain profitability benchmarks.
How Waterfall Structures Work in Practice
In most cases, if a waterfall structure is used in a commercial real estate investment, the exact nature of the structure is laid out in the owner's agreement. The entire structure is usually based on something called a 'return hurdle,' a specific amount of profit that the project needs to generate in order to progress to the next hurdle.
Usually, this is defined by a project's internal rate of return (IRR). So, for example, if a sponsor invested 5% equity in a project in a $1 million project ($50,000), and an investor invested 95% ($950,000), the first hurdle could be a 9% IRR. For any returns below 9%, the sponsor gets 5% of the profits, and the investor gets 95%. However, for any returns above 9%, the sponsor gets 10% of the profits, and the investor only takes 90%.
If, for example, the project generated a 12% IRR in the first year, that would equal $120,000 in profit (assuming no taxes.) The sponsor gets 5% of the first 9% ($90,000), which equals $4500, and then takes 10% of the profits above 9% ($30,000), which equal $3000. So, in this case, the sponsor would get $7500, getting a 15% return on their investment, while the investor gets $112,500, getting an 11.8% return on their investment.
Many waterfall structures have multiple hurdles. For instance, in the example above, there could also be return hurdles at 13% and 16% IRR. Each of these would provide the sponsor a greater proportional return, say, 15% and 20%, on the profits over those amounts.
Preferred Return in Waterfall Structures
In many equity waterfall structures, there is also something called a preferred return. This allows certain, preferred investors a first claim on the profits until they achieve a specific rate of return. In the example above, if the preferred return for the investor is set at 8%, and the property only generates a 7% IRR, the investor gets as much of the profit as it takes to reach that 8% hurdle, even if it left the other investor (in this case, the sponsor, with nothing.) Which it would, if we calculate it.
If this distribution happens upfront, it's called a catchup provision. In other cases, it is structured as something called a lookback provision. This stipulates that, if, by the end of the deal, the preferred investor has not met their preferred return hurdle, the sponsor has to give back any profits they have received until the investor reaches it.